How to Decide if an adjustable rate mortgage is Right for You

An adjustable rate mortgage, called an ARM for short, is a mortgage with an interest rate that is linked to an economic index. The interest rate, and your payments, are periodically adjusted up or down as the index changes.

ARM Terminology

Index

An index is a guide that lenders use to measure interest rate changes. Common indexes used by lenders include the activity of one, three, and five-year Treasury securities, but there are many others. Each ARM is linked to a specific index.

Margin

Think of the margin as the lender’s markup. It is an interest rate that represents the lender’s cost of doing business plus the profit they will make on the loan. The margin is added to the index rate to determine your total interest rate. It usually stays the same during the life of your home loan.
Adjustment Period

The adjustment period is the period between potential interest rate adjustments.

You may see an ARM described with figures such as 1-1, 3-1, and 5-1.

The first figure in each set refers to the initial period of the loan, during which your interest rate will stay the same as it was on the day you signed your loan papers.

The second number is the adjustment period, showing how often adjustments can be made to the rate after the initial period has ended. The examples above are all ARMs with annual adjustments–meaning adjustments could happen every year.

If my payments can go up, why should I consider an ARM?

The initial interest rate for an ARM is lower than that of a fixed rate mortgage, where the interest rate remains the same during the life of the loan. A lower rate means lower payments, which might help you qualify for a larger loan.

How long do you plan to own the house? The possibility of rate increases isn’t as much of a factor if you plan to sell the home within a few years.

Do you expect your income to increase? If so, the extra funds might cover the higher payments that result from rate increases.

Some ARMs can be converted to a fixed-rate mortgage. However, conversion fees could be high enough to take away all of the savings you saw with the initial lower rate.

ARM Indexes

While you can’t dictate which index a lender uses, you can choose a loan and lender based on the index that will apply to the loan. Ask the lender how each index used has performed in the past. Your goal is to find an ARM that is linked to an index that has remained fairly stable over many years.

When comparing lenders, consider both the index and the margin rate being offered.

Discounted Rates and Buydowns

When you’re buying a home you might encounter sellers who offer to pay a buydown fee that allows the lender to offer you an initial rate that’s lower than the sum of the index and the margin. New home builders sometimes offer that type of purchase package to help get people into their homes.

The buydown rate will eventually expire and your payments could rise significantly if an ARM rate is adjusted upwards at the same time the discount expires.

Keep in mind that sellers sometimes raise the price of a home by the amount they pay to buydown your loan. The extra cost may in time override any savings from the initial discount.

Interest Rate Caps

Rate caps limit how much interest you can be charged. There are two types of interest rate caps associated with ARMs.

  • Periodic caps limit the amount your interest rate can increase from one adjustment period to the next. Not all ARMs have periodic rate caps.
  • Overall caps limit how much the interest rate can increase over the life of the loan. Overall caps have been required by law since 1987.

Payment Caps

A payment cap limits how much your monthly payment can increase at each adjustment. ARMs with payment caps often do not have periodic rate caps.

Carryovers

If an interest rate cap held your interest down at an adjustment even though the index went up, the amount of the increase can be carried over to the next adjustment period.

Beware of Negative Amortization

Amortization takes place when payments are large enough to pay the interest due plus a portion of the principal.

Negative amortization occurs when payments do not cover the cost of interest. The unpaid amount is added back to the loan, where it generates even more interest debt. If this continues you could make many payments, but still owe more than you did at the beginning of the loan.

Negative amortization generally occurs when a loan has a payment cap that keeps monthly payments from covering the cost of interest.

The Bottom Line

Lenders are required to give you written information to help you compare and select a mortgage. Don’t hesitate to ask as many questions as it takes to help you understand every aspect of ARMs and other home loans that are offered to you.

Foreclosure By Walking Away

The housing market has been a wild exhilarating and joyful ride up these past several years only to nose dive down with increasing speed and equal frustration. The stomach turns within the belly of the homeowner, as this once profitable investment becomes a heavy weight around his or her family’s neck. Mortgage Millstone; perhaps a fitting name for the negative equity experienced by millions upon millions of Americans today. Our finances affect our lives, our disposition, and our ability to function from day to day. So, what to do? Some say simply to walk away.

Have you ever failed a test? I’ve failed a test. I’m sure we all have at some point. Whether academic, work-related, personal, etc. we’ve all failed a test; but does it stop there? Do we throw the proverbial baby out with the bath water? Wouldn’t we be failing another test in so doing?

I’ll argue that at this point the test for homeowners is ongoing. But what are the rules? The rules and the goals are what defines your next coarse of action. Ultimately, what matters is where you will be in the future and not where you are today. The game is halfway done and the test is not over until the end of the game.

Lenders have failed the test too. Mortgage loans are upside down. The Federal Reserve Chairman Ben Bernanke in a March 4, 2008 speech suggested: “In my view, we could also reduce preventable foreclosures if investors acting in their own self interests were to permit services to write down the mortgage liabilities of borrowers by accepting a short payoff in appropriate circumstances.” This is a profound suggestion and one that could provide a passing grade for millions.

Your mortgage loan can be written down to a lower balance and forgiven. This is something that I personally am seeing being done every day. A mortgage loan that is $100,000 higher than the value of the home is written down by $100,000 and that $100,000 is forgiven. Poof! An instantaneous passing grade is achieved in real estate.

With a reduce mortgage balance a homeowner can refinance the mortgage to an FHA mortgage loan with a 5.5% fixed rate of interest. With a reduce mortgage balance a homeowner can sell the home on a short sale to a new buyer. With a reduced mortgage balance a homeowner can avoid foreclosure. With a reduce mortgage balance a homeowner can pass the test!

In any of the above scenarios where the mortgage lender reduces the principal balance of the loan for the homeowner to facilitate a short payoff for a refinance or a short sale, the homeowner is able to preserve his or her credit standing. This has the effect of controlling the damage done to that homeowner’s reputation in functioning in business and in life. About half of the state foreclose through judicial process and the foreclosing lender can then pursue a deficiency judgment against the homeowner immediately or can bring a suit under common loan years later based on the defaulted note. This article is not to be considered legal advice. It’s just some of the issues that one needs to investigate with an attorney.

Yet, some say walk away. This is insane; walk away and leave the test. Walk out of the school and leave the test. Holding your head low forever. This is not responsible. This is not a solution. This, my friends, is simply failing the test.

Second Mortgage or Remortgage: Which Should I Choose?

A second mortgage is not the same as a remortgage. There is a lot of confusion about this. Second mortgage and remortgage are different ways of getting hold of the equity in your property.

If you have had your mortgage for a fair length of time, you have probably noticed that the value of your property has increased. The most likely way to find this out is if a neighbour’s house similar to yours goes on the market, and you get a surprise when you see how much it is going for.

If this increase has in fact taken place, the difference between the amount of the outstanding mortgage (plus any other loans secured on your property) and the current value of your house is the equity. Using this equity is one of the most sensible ways of raising extra cash if you need it for any reason.

Basically there are three ways of using your equity:

  1. Refinance your mortgage with your existing lender
  2. Remortgage with a new lender, for a larger loan.
  3. Keep your existing mortgage as it is and take out a further loan secured on the equity in the property. This is what is called a “second mortgage”.

Each of these methods has its pros and cons.

  • The advantage of staying with your existing lenders is that they are familiar with you and your payment record, and also with the property. So there should be fewer checks and formalities to go through, to refinance the loan. However, if it’s a long time since you took out the first mortgage, they may still need a new valuation. They may also need a check on your finances – they know whether you’ve kept up your mortgage payments or not, but they don’t know what other financial commitments you may have.
  • Sometimes you can actually do much better by switching to a new lender – you may get better rates, as lenders often reserve their best rates for new customers! It quite often happens that people remortgage with a new lender for a much bigger loan, and actually end up with lower monthly payments than before. The lenders will of course need surveys, valuations, credit checks, etc.
  • If you take out a second mortgage, this becomes a “second charge” on the property, with the lenders of the original mortgage keeping the deeds. This means that if the house is sold or repossessed, the lenders of the first mortgage have first claim to repayment. The holders of the second charge then have the next claim to recover what is owed to them. The lenders of the second mortgage thus have a higher level of risk, and so their interest rates may be higher than those for the first mortgage. However, they are still competing for your business, so you can still get very good deals on your second mortgage if you shop around. And the rates will certainly be better than for an unsecured loan.

Whichever of these methods of utilizing your equity you choose, lenders are very unlikely to release the full value of the equity. They will always wish to retain some equity in the property in case of a fall in value or other emergency. However, if you are looking for a second mortgage, it is possible in some cases to find a lender who will go up to 100 per cent – at much higher rates, to reflect the higher risk.

Whether a second mortgage or a remortgage is better for you will depend on your individual circumstances. A broker or financial adviser will help you decide what’s best for you.